Apparel Series II: Retailer Pitfalls

Some things never change

This is the second part of my series on Apparel. This article goes deeper into specific aspects of apparel retailing and summarizes my opinion on 11 retailing companies, mainly from the US. When I started studying retail, my first questions concerned the industry's general competitive challenges, such as how to survive the mega-retailers like Amazon or Shein, which positions are more desirable, and how to deal with B&M store heavy retailers. That is covered in Value Hunting in Apparel Retail.

I concluded that apparel is an industry that can offer protection from these hyperscalers because it is fragmented into multiple brands and segments. Each brand has a specific business model and an aesthetic and emotional bond with customers that are difficult to copy. The more differentiated and upmarket players are preferred against more undifferentiated, third-party inventory sellers focused on value and assortment.

In this part, I go a bit further and distinguish between apparel retailing and manufacturing. Simply put, retailers are service brands, and manufacturers are product brands. This distinction matters because these two apparel categories have very different competitive dynamics and require different management capabilities. I'll elaborate on this in Section 1.

Then, in Section 2, I dive more into apparel retailing, treating specific pitfalls that retailers can fall into. Specifically: 

• What extra challenges do third-party brand retailers face?

• Are promotions a good long-term strategy to boost sales and clear inventories?

• Is inflation damaging low-price retailers or competition from ultra-fast fashion like Shein/Temu?

Finally, in Section 3, I summarize my thoughts on several apparel retailers, applying the concepts I discussed in this series. The companies are grouped based on common factors that impact them similarly 

• Turnaround: Destination XL (DXLG) and Children’s Place (PLCE).

• Model question mark: Stitch Fix (SFIX).

• Shein’s lunch: Citi Trends (CTRN) and Cato (CATO).

• Challenged assortment: Tillys (TLYS) and Zumiez (ZUMZ).

• Record-margin footwear retailers: Hibbett (HIBB), Caleres (CAL), Shoe Carnival (SCVL), and Genesco (GCO).

I have also been reviewing many ‘manufacturers,’ such as Guess?, G-III, Duluth, Canada Goose, Renner, Figs, and some European ones. The third part of this series will delve into these and some of their challenges, like fashion cycle risks, market size limits, luxury confirmation bias, luxury models, and DTC integration challenges.

As always, I hope you enjoy it, and please send me your feedback!

1. Retailers and manufacturers, service and product

Generally, screeners divide apparel companies between Apparel Retailers and Apparel Manufacturers (the latter sometimes called Apparel, Accessories, and Luxury Goods). This is a little confusing because some apparel retailers do manufacturing and vice versa. Also, ‘apparel manufacturing’ makes me think of a sweatshop (or a large integrated company like Gildan Activewear), but the category includes some of the top luxury and ready-to-wear brands.

However, the classification makes a lot of sense and helps us think about two broad sets of capabilities: creating a great product or providing a great service. Only a handful of companies can do both well.

Apparel retailers

Apparel retailers focus on service. They promise that in their stores (physical or not), the customers will find a specific type of apparel at a competitive price range and that the experience will be fantastic. In the mind of the customer, the brand of an apparel retailer is tied to finding great products, not the great products themselves. This is a subtle but important distinction.

I divide these retailers into subcategories depending on how they segment their markets. These are demographic, style, and price, with some being a mix.

Examples of demographic retailers are Destination XL for large men or Children’s Place for (you guessed it) children. Destination carries many styles and price ranges, but the assortment and experience are tailored for the big and tall category.

Tillys, Zumiez, and Hibbett are examples of style retailers. They service a specific fashion customer segment. Sometimes, this style segment will coincide with a demographic segment.

Finally, price retailers promise generally on-trend, fashionable products at a specific quality/price ratio. Citi Trends offers apparel (and other products) for all the family, but the premise is that they are cheap. I would say that many of the fast fashion giants (Zara, H&M, or Renner) are also in this category because they focus on a specific price and quality ratio while offering fashionable products that are always on trend.

The problem of apparel retailers is that a big part of the competition is based on price and assortment, an area where building a moat is challenging. Other competitive factors like location and advertising are also easy to arbitrage away.

That is why the most successful apparel retailers have integrated vertically into manufacturing and private labeling - or at least direct contracting and product development. This includes all of the fast-fashion retailers. As I will elaborate on Section 2, the idea is that their models become more defensible by controlling assortment supply, and that not doing so harbors severe risks. 

When evaluating apparel retailers, I focus on understanding differentiation factors that make their promises more unique. Some of these are exclusive assortment, difficult-to-get locations, and lack of large competitors in the same customer segment. While some retailers do manage to differentiate on service, this is generally more valuable in the upper segments of the market.

Apparel manufacturers

The core capability of the apparel manufacturer is building a brand around a product line. In this respect, the apparel manufacturer is like a CPG company.

The product or the manufacturing is only important as a vehicle for the brand. In fact, many ‘apparel manufacturers’ are not actually manufacturers; they outsource (but tightly control) that part of their value chain. I believe the name should be changed to apparel developers or wholesalers.

Apparel manufacturers sell what Erica Corbellini calls ‘The Dream.’ It is the promise that the customer will become something else by purchasing a product. They communicate this dream via marketing and ensure that their product and retailing are consistent.

Retail product contribution margins north of 60% are not uncommon in this market, signaling that the product quality/price ratio is secondary in customers' minds. This is valid both for up-market companies (think LMVH) and mass-market companies (Nike or Columbia).

Because the company's focus is on intangibles, the model is much more defensible, especially after the brand is well established. The product is ideally unique, totally decommoditized, and cannot be found (or compared in price) with anything else. This is particularly true for designer and luxury companies.

Apparel manufacturers are, therefore, in a much better position to defend against the mega-retailers and can, in fact, can even form alliances with them to broaden their market reach. In this sense, the manufacturer is channel agnostic.

A different group is that of actual apparel manufacturers, like Gildan Activewear, or many Asian companies. These companies focus on cost and manufacturing efficiencies and are a different animal altogether, treated in Part III of this series. 

2. Retailer challenges and pitfalls

Following are some more specific thoughts on operational differences between retailers. We have already discussed aspects like brand creation, customer targeting, and service focus. The following topics are more operational but still significant when evaluating a retailer. They are particularly relevant in a context like today’s, where demand is somewhat shrinking, and competition is becoming more fierce.

The perils of selling third-party brands

Companies that sell primarily other people’s products without any additional twist have a hard time avoiding price competition. 

The best example of this group is footwear retailers. Footwear is fantastic for manufacturers, a heavily branded product that is relatively decommoditized. It is terrible for retailers, though, because identical Nike shoes can be searched for online and compared by price. A Nike pair is fungible for customers with another Nike pair, even though it is not fungible with, say, Adidas shoes.

In cases like this, where the retailer has no exclusive product, and the wholesaler does not impose promotional limits, gross margin volatility can be high. This makes any retailer in this situation more undesirable as an investment, as it faces much higher downside risks during a downturn. Other areas have to be stronger, such as location, target customer specificity, and, above all, operational efficiency, frugality, and cost leadership.

Examples outside of footwear retail include Zumiez and Tillys, two companies targeting the same demographic, carrying mainly 3P brands, and struggling with sales.

Another mention is supplier concentration, for example, Hibbett or Foot Locker with Nike. Bronte Capital has an interesting theory of why the demographics targeted by Hibbett give it some bargaining power with Nike. 

Promotion hell

The more companies analyzed, the more I believe that a company running aggressive promotions is a sign that its management prioritizes the short term over the long term.

Particularly in the current context and among assortment retailers targeting middle or lower-income classes, it is prevalent to blame the ‘highly promotional environment’ for falling gross margins. Sometimes, managers even pride themselves in ‘running strategical promotions during the quarter.’

There are many problems with running promotions.

First, the same promotion must be offered to all clients, reducing producer surplus in favor of consumer surplus. A client that would have bought at $100 buys at $80 so that we can sell to another client at $80 as well. Second, the promotions sometimes reduce the contribution margin so much that it would be better to lose sales than to do the promotion. This holds especially true when the contribution or gross margin is low. If you sell something at $100 for a gross margin of $30, you’re better off selling that piece than selling two at $84. The 16% discount generated 68% higher sales ($168) but lower gross profits ($28).

This happens because there is a perverse incentive that leads managers to choose promotions. Promotions increase revenue while keeping gross profits flat (or, as above, even reducing them). They are generally just a transfer of earnings from one customer to more customers. However, that pays off because the market is more fixated on growth than on profitability (or the strategy's long-term viability). The market likes revenues going up, even though they generate flat or falling gross profits. 

Third, excessive promotions train customers to wait for the promotional season to make their purchases, eventually alienating the highest-value customers. This was exemplified in Duluth’s 4Q23 earnings call by the company’s CEO.

The (QC: highly promotional) Black Friday weekend through the midpoint of Cyber Week was the strongest sales results we've seen in the history of the company.

As the holiday season played out, it was clear that it pulled sales forward from the weeks leading up to Christmas where we typically do more business at higher margins. And so that was a bit tough.

On the other hand, Destination XL has been running a successful no-promotion strategy. They did no promotions in 4Q22 or 4Q23. Their gross margins are 500 basis points higher than pre-pandemic, and sales have not decreased much despite the challenging context.

Fourth, and specifically for manufacturers/retailers, running promotions commoditizes the product. It makes it comparable to other stuff that is on promotion. Unless the brand proposition is ‘low prices every day,’ having some induced scarcity and people that can’t buy is not terrible; it creates subjective value. That is why discounting is anathema in fashion.

Finally, heavy promotions hide merchandising or other operational failures. The company can find itself once with inadequate inventories or too inventoried into a downturn (this was common in 2022 and 2023). However, if the situation is not corrected after one season, it signals a planning problem that should be addressed.

Value retailers are bleeding, is it inflation or ultra fast fasion?

Most retailers that sell to lower-income customers are facing grave revenue declines since 2022. Examples of this are Cato or Citi Trends. At the same time, some premium-priced retailers are growing.

When listening to these companies’ calls, inflation is always the culprit. The rationale is that people spend more on food and gas and less on apparel. It also makes sense that more premium-targeted retailers are doing better, as their customers have more disposable income. 

However, I believe that these apparel retailers are losing against Shein or Temu, not against inflation. The retailers’ proposal is ‘lower prices every day,’ and their customers obviously look for the best prices at the expense of other characteristics, like convenience. Temu or Shein offer much better value in this segment if one is willing to wait for delivery.

If that is the case, then cheap, value apparel retailers like Citi Trends or Cato will not recover with a macroeconomic improvement because their demand has moved away.  

3. Hands-on company reviews

This section provides a summarized thesis of the situation for around 14 retailers. The original, more detailed articles were published in Seeking Alpha.

They are grouped according to shared characteristics or situations, which I believe provide valuable insights on how to approach apparel retailers, using the criteria outlined in this series.

Promotional turnaround: Destination XL (DXLG) and Children’s Place (PLCE)

Both Destination XL and Children’s Place are companies with dismal operations that led them close to collapse. Both of them suffered from excessive promotional activity, which led to decreasing margins and alienated customers. 

Destination XL

Disclaimer: I have a position in DXLG.

Destination XL has a niche focus on overweight men. It offers a whole-line assortment (formal to sports, low to high end), with exclusive products across leading brands. They are praised for their customer service. Despite them offering a range of prices, I believe high-end sales are dominant, because their gross margins pre-rent are close to 60%. 

The company’s operations pre-pandemic were dismal, opening too many different store concepts and running heavy promotional activities. In 2019, a new CEO and managerial team were brought in. 

I think this team is executing, here are some indications:

• Great SG&A management, SG&A is fixed despite opening stores, increasing advertising by $10 million, and a 30% increase in labor costs. 

• Stopped most promotional activity, which has led to stable contribution margins even though the company has not been growing for a year and a half. 

• Did not overspend CAPEX during the pandemic boom.

• Launched e-commerce and apps, plans to revamp in 2024.

• Launched a customer loyalty program.

• Inventory turnover is up, even with sales down last year.

• Announced a new distribution channel in alliance with another retailer for spring 2024.

One of the things I don’t like about Destination XL is the brand-building potential around being overweight. This year, the company launched its first media campaign in years, ‘Wear what you want.’ Last quarter, they also announced hiring an advertising agency and increasing advertising expenses by two percentage points. 

The company’s SG&A plus rent is $260 million, 47% of revenues. DXLG’s current gross margins exceed 62%. At 60% contribution, sales can fall 22% before operational breakeven. Assuming 4% operating margins (against a current 8%) and 10% lower revenues, it still trades at 9x EV/NOPAT.

Children’s Place

Children’s Place was driven to the ground by terrible managerial decisions. They invested heavily in brand-building advertising (hiring Snoop Dog and Mariah Carey to run Holiday ads this year). At the same time, they ran brutal promotions, offering up to 80% off everything on their website. 

This led to the company announcing covenant breaches and the stock collapsing. A Saudi value fund bought blocks of shares and took control (50%+ ownership). Currently, PLCE is still in flux. New controllers want to replace all the Board and CEO and recapitalize (probably via rights plus convertible debt). Potential recapitalization of all debt at current share prices implies future dilution to 1/5 of the current stake.

Children’s Place’s problems are self-inflicted. Revenues fell $300 million from the peak, but adjusted CoGS (ex-rents) has not fallen, meaning all the revenues lost were due to higher promotional activity. Because of such excessive promotions, PLCE could raise prices by 20%, lose up to 30% of volume sales, and still make more money than today.

In both full and zero equitization of debt scenarios, EV/NOPAT multiples are very attractive if the company can apply lower promotions and lose sales. However, for the time being, it’s extremely risky; no 10-K filed for FY23 despite results for Q4, which should’ve been published weeks ago

Model question mark: Stitch Fix (SFIX)

Stitch Fix is the leader in an innovative model called style boxes, where customers pay for a bundle of apparel chosen for them with the help of a stylist. 

This model works great for people who are not very into fashion and need help creating wardrobes. The company grew like crazy during the pandemic. However, during this time, it was losing a lot of money and camouflaging it behind massive SBC, protecting cash but diluting the company’s value. Then things reversed; ‘the market’ asked for profitability, and Stitch Fix cut on advertising expenditures and employees. As a result, sales growth quickly reverted, and the company started bleeding customers.

I think Stitch Fix’s problem is more profound. The company’s customer is fundamentally different from that of almost any other apparel retailer because the premise is that the customer does not like apparel in the first place. That is why Stitch Fix is helpful. However, as soon as the customer has renovated the wardrobe, he stops purchasing from SFIX. 

This means that SFIX needs to spend a lot in CAC but that their CLTV is extremely low because the target customer does not like to spend money on apparel to begin with. By checking the average spend per customer and the number of active customers one can learn that most customers get two ‘fixes’ (~$250 each) and then never purchase again, because they have solved their wardrobe problem.

The company recently hired a new CEO who is still working on positioning. I think Stitch Fix’s model could work for a much smaller market and with a correspondingly much smaller structure. 

PD: Most screeners and databases do not include the massive dilution from SBC in SFIX’s market cap or EV because those shares and options are anti-dilutive. All exercisable options and stock should be added to the company’s market cap. 

Shein’s lunch: Citi Trends (CTRN) and Cato (CATO).

Citi Trends and Cato explicitly offer low prices to their customers. They are targeting the lower income brackets or people looking for price. 

Their sales are falling compared to the pandemic stimulus boom (something that could be expected) and even against their pre-pandemic levels. This is indicative that Citi Trends and Cato are not only fighting against inflation and a challenging macroeconomy but also against the cheap-product giants Shein and Temu. In fact, I believe Shein and Temu explain Citi Trends’ and Cato’s current problems more than the macro, as explained in Section 2. 

Both companies have a lot of cash and trade at low multiples of historical earnings. For example, Cato trades at a negative EV or a market cap of $100 million against an average of $40 million in EBIT figures pre-pandemic. 

Many people are expecting a cyclical recovery in these names, but I think their challenges are more fundamental, and that they might not recover their pre-pandemic glory days. 

Challenged third-party assortment: Tillys (TLYS) and Zumiez (ZUMZ)

Tillys and Zumiez are retailers of third-party brands with a big presence on the West Coast and the same customer segment (teenager to twenty-somethings streetwear). The companies’ revenues are decreasing fast, at double digits. They have lost both topline and gross margins. 

They illustrate why selling third party products is dangerous. Even though they are not running super heavy promotion, Tillys and Zumiez are losing sales to competitors selling the same brands at heavier discounts. 

Both Tillys and Zumiez have large cash stashes and are discounted on an EV to historical EBIT basis. I like them more than Cato or Citi Trends because I do not see a fundamental challenge to the business. However, I am not sure that their problems are just cyclical issues.

Footwear retailers: Hibbett (HIBB), Caleres (CAL), Shoe Carnival (SCVL), and Genesco (GCO)

Footwear retailers are a category I don’t particularly like because of the third-party brand retailing problems discussed above. However, they are not showing as many difficulties as other assortment plus price based retailers. In particular, store productivity continues to be high (with the expectation of Genesco), driving record margins.

In an inverse proposition to challenged retailers like Zumiez, Tilly’s, Citi Trends or Cato, the footwear retailers trade at a discount to current earnings, meaning the market expects a return to the mean of lower profitability. 

The management teams from these companies talk about not needing to run so many promotions and having good inventory levels. Compared to the pre-pandemic period, I cannot think of company-specific drivers for this change and agree that margins and profitability should return to the mean.

Hibbett should receive a special mention. It currently offers a wider ‘margin of safety’ in terms of multiple over pre-pandemic earnings. Also, its margins are not as high compared to pre-pandemic values. Although it is significantly dependent on Nike’s sneakers, it has a more segmented/niche proposition than the other retailers (more on the full-family any-occasion assortment type). It focuses specifically on the young African American youth of rural and suburban southeast, where competition is lower and customer value is higher.

Wrapping up 

With a few exceptions, small and mid-cap apparel retailers in the US are challenged right now. Part of the problem is the macroeconomic cycle. However, management teams always have alternatives, as illustrated by the disparity of outcomes. 

These retailers suffer from a position that is too reliant on assortment and low prices and too dependent on third-party products. The problem is compounded by management teams addicted to running promotions. The surge of super-cheap Chinese competitors like Shein or Temu is just fueling the fire. 

Hopefully, understanding these positioning and strategic problems will help us avoid value-traps and find out early when managerial teams are taking bad decisions that will lead to lower profitability in the future. 

On the next part on apparel we will look at manufacturers (both real ones and not), and find a very different competitive landscape, which leads to a much better situation generally, despite the same challenging macroeconomic context. 

As always, thanks for reading! If you liked it, please share it. If you have suggestions, send them my way.